Tightening of liquidity in Oman due to higher government borrowings to bridge budgetary deficit is pushing interest rates up and making things difficult for businesses in the country.

Troubled finances, following the softness in global crude prices, have been forcing the government of Oman to raise money through debt to bridge the gap between earnings and expenditure. Aggressive borrowing by the government from both local and overseas markets along with the withdrawal of state deposits from local banks have created a situation in which liquidity is being squeezed out of circulation thus raising the cost of funds for companies.

As per the data available from the Central Bank of Oman (CBO), last year Oman raised around RO2.48bn by selling bonds in both domestic and overseas markets to bridge the budget deficit. However, as crude prices have continued to trade lower there are apprehensions that continued borrowing would result in further decline in bank deposits and will reduce the availability of funds for lending.

"The liquidity in the market is tight due to decline in bank deposits amidst continued higher borrowing by the government because of lower oil prices resulting in a situation where too many players are chasing the same money and this has resulted in interest rate hike," says Shahin Mohammed al Balushi, CEO at Oman ORIX Leasing Company.

He says, "When oil prices were trading higher i.e more than US$ 70 per barrel, everything was good. There was enough funding available for everyone and banks had higher deposits with them. The market was very liquid and interest rates were low. But as the oil prices have plunged,  revenues from oil sector have fallen and things have changed rapidly.

"To cope with the situation, the government has started to rationalize expenditure as it is the main driver of the economy and everybody is feeling the heat," says Balushi.

In its latest monthly report, CBO stated that aggregate deposits held with conventional banks in the country fell by 3.4 per cent to RO17.9bn in May 2016, from RO18.6bn a year ago. At the same time, government deposits with conventional banks also declined by 16.4 per cent to RO4.5bn. Though a part of it moved to Islamic banks, overall government deposits fell in Oman.

In the case of the domestic interest rate structure of conventional banks, the weighted average interest rate on rial deposits firmed up from 0.908 per cent in May 2015 to 1.163 per cent in May 2016, while the weighted average rial lending rate decreased from 4.948 per cent to 4.835 per cent during the same period. The overnight domestic inter-bank lending rate of the rial firmed up to 0.385 per cent in May 2016 from 0.146 per cent a year ago, the CBO report said.

Shift in position

In the period between 2012 and 2014, Oman's finance market witnessed the creation of additional lending capacity to the tune of RO8bn and there weren't enough avenues to invest. As a result margins in the finance sector came under pressure. Until mid 2015, there was ample liquidity in the financial system. And the banks, with surplus liquidity and excess underutilised lending capacity, were competing with non banking finance companies for lending to consumers and small and medium enterprises.

However, the sharp fall in crude prices in the second half of 2015, and early this year, saw rapid changes come into effect in the financial market.

Most companies particularly finance and leasing, and contracting companies operating in Oman have expressed their concerns that tightening of liquidity has pushed interest rates higher. As the returns on assets grew slower than liabilities on lending, there are chances that increased interest cost could hit margins in the coming quarters.

"Our raw material is money and when liquidity tightens cost of money goes up. And the cost of raw material has gone up in past few months," says Robert Pancras, CEO at National Finance.

He says when cost of funds goes up, the spread between lending and borrowing interest  become narrower. NBFC lending is mostly at fixed rates for the lease periods. So in such a situation, margins get impacted as the average lending rates go up with a time lag whereas interest costs rise quickly. It takes some time before the increased interest rates on new loans restore the overall interest spread for NBFCs.

Agreeing to this, Balushi says "Due to the rising interest cost there is pressure on the margins and interest rates have been adjusted keeping in view the market reality."   

According to industry experts, most finance companies felt the pinch in the first quarter as they posted lower profit growth in the first quarter of 2016 compared to the double-digit growths recorded in the same period last year. Going forward, NBFCs, also known as leasing and finance companies, foresee a challenging year ahead with margin pressures continuing to remain high.

Bridging the gap

Oman faced a budget deficit of RO4.5bn in 2015 from a surplus of RO233.4mn a year earlier. And in 2016, the country is likely to see a budget deficit of RO3.3bn. To bridge the deficit, Oman has begun spending cuts, raising taxes and initiating fuel subsidy reforms. The country has an extended domestic borrowing programme, including regular treasury bill auctions. The borrowing is adding pressure on liquidity in the local banking system and forcing the government to raise money from abroad.

CBO executive president H E Hamood Sangour al Zadjali earlier said that the government might issue bonds by the middle of this year as part of a plan to raise up to US$10bn from overseas markets.

He says, "CBO has been continuously reviewing the liquidity situation and no significant pressures have been noticed. Some relative tightening may have emanated given the containment of government expenditure. Going forward, if the oil prices continue to remain low, there may be some impact on individual banks' liquidity profile leading to higher competition among banks for sourcing of funds.

"Given the current low interest rate scenario, the market will have to factor in this competition and an upward movement can be expected in interest rates."

According to industry insiders, high interest costs will severely affect small and medium contractors who don't have enough cash to run their daily business. As government payments are also getting delayed, many have to borrow more money from financial institution particularly for the short term as they have to pay regularly for equipment, fuel, salaries and other day to day expenses.

"The tighter liquidity available through the banking sector obviously affects companies that are more indebted. However, the problem of delayed payments to contractors should be resolved swiftly given that the government is completing its programme of debt issuance," says Fabio Scacciavillani, chief economist at Oman Investment fund.

He adds, "Government borrowing inevitably crowds out private investments because it reduces the amount of savings available to the private sector. The severity of this crowding out depends on several elements, for example the inflow of foreign capital, the willingness of the private sector to undertake new investment projects and the sensitivity of private savings to higher interest rates."

Ray of hope

Industry officials are maintaining that the liquidity situation was heading towards a much bigger problem until few months back when crude touched the lowest level in more than 12 years and the government was borrowing aggressively. But April onwards things have started to ease as a result of some positive steps announced by the government and CBO.

As a proactive measure, CBO decided to permit banks' investment in unencumbered treasury bills, government development bonds and Oman government sukuk to be a part of the eligible reserves to be held with CBO up to a maximum of two per cent of deposits effective April 1, 2016. It is contemplated that this move will have the effect of boosting banks' liquidity by about RO400mn, thereby increasing the lendable resources available with them in Oman.

Aftab Patel, CEO of Al Omaniya Financial Services, says, "Due to various proactive and risk mitigation steps initiated by the Central Bank of Oman and the government, the country has been able to reduce the impact of low oil prices and keep the economy on an even keel".

On the impact of liquidity, Patel says, "We have definitely seen some sharp increase in the interest cost in the last five months, the cost of deposits has also substantially increased.  We know hat low oil revenues will constrain liquidity, however thanks to steps initiated by the Central Bank of Oman, there is no shortage of money in the system. Having anticipated this quite early, Al Omaniya has created a cash buffer by holding substantial cash balances as at the end of 2015."

Despite the government's best efforts to diversify the economy to non-oil sectors, earnings from hydrocarbons still dominates state finances. And everybody is hoping for a recovery in crude prices. If there is an exorbitant delay in the recovery, the government will be forced to take more stringent measures like further cuts in expenses and raising more debt from more local sources. These factors could push interest rates up and create a shortage of funds, making things difficult for business in the country.

Meanwhile, the government has announced that it would issue more dollar denominated bonds in the coming months, which has raised hopes that things could get better in the near future. 

© businesstoday 2016